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Tuesday, January 25, 2011

Shiller and Economic Science

The financial crisis was certainly unanticipated, and there are features of it that are complicated, with various anomalies relative to historical experience. We have already learned a lot. At the minimum, your average economist and layperson now understand a lot more about the nature of financial derivatives, the mortgage market, and financial intermediation in the United States than they did in the Spring of 2008. But there is much that remains to be sorted out. As economists, we now have fertile ground for future research, and the problems are fascinating.

One particularly interesting feature of the financial crisis and the recent recession has been how it has affected the struggle among economists over basic ideas and methodology. Generally, economists seem to see this as an opportunity for a shakeup. You can't blame people for trying. Why not use the financial crisis as an opportunity to make peddlers of ideas I disagree with look stupid, and to make my ideas look good? I have done this from time-to-time myself. I like to argue that New Keynesians, who had a lot of influence over central bankers and monetary policy pre-crisis (and still do), missed the boat on financial factors and their role, and left us with models that could not tell us what to do in the crisis. I think that real business cycle types (if there are any pure RBC types still around) missed the boat as well - the RBC approach typically downplays monetary and financial factors as being nothing more than a sideshow. Like everyone else, I'm trying to push my ideas, which are that financial intermediation, monetary exchange, liquidity, and credit markets are important. Other people are pushing in other directions. This one wants us to throw out modern macroeconomics and go back to 1937. Some others want to push behavioral economics. Some New Keynesians want to argue that they can retain most of their existing framework and fix things with modest extensions.

What is Shiller up to? Well, like everyone else, he is using the crisis to peddle his ideas. He first argues that the general public has "lost faith" in the economics profession for its lack of foresight with respect to the financial crisis. I would characterize the situation in a different way. For the most part, economists are ignored. We are not like the doctors, used car dealers, lawyers, etc. Most people do not consult economists on any regular basis, and we are not the subject of many television programs or films. There are no economics-profession-counterparts of "House," or "Wall Street." Economists are just not that exciting. I felt sorry for Paul Giamatti, who will have to portray Ben Bernanke in "Too Big to Fail," an HBO movie. What's next? "The Economists," with Dustin Hoffman as Mike Woodford, Jeff Bridges as Larry Jones, Rick Moranis as Randy Wright, and Gwyneth Paltrow as Deirdre McCloskey? What idiot would finance that film and risk losing his/her shirt?

To the extent that anyone now pays attention to us, it's either because they actually want to learn about the financial crisis, or because they enjoy a good fight; i.e. economics is like a hockey game. In contrast to the medical profession, we don't close ranks, but instead prefer to pummel each other in public. That has to be entertaining on some level. Even when the controversy isn't there on the surface, journalists will go looking for it, and they can always find some fringe economists willing to criticize the rest of the profession. Now, speaking of the medical profession, what have they done for us lately? Most of us die in hospitals, where the concentration of doctors is highest. Explain that to me.

Anyway, Shiller's point seems to be that economists should think outside the box. Of course that is hard to argue with. Research is about thinking outside the box and coming up with novel and useful ideas. I think that, in general we are rewarded for doing that. However, Shiller does not seem to think so. Indeed, he appears to be questioning the whole formal structure of academic peer review, and suggests that we don't properly reward grass-roots thinking. According to him, economists are divorced from reality, and they need to do more popular writing that is accessible by the lay person. I could not disagree more. Popular writing may not be rewarded by the tenure review committee, but it has its own reward. Just ask Steven Levitt, who is rolling in cash. To be treated seriously as a science, which I think is important, we have to do proper peer review and go through the formal publication process. That's the only way to properly sift ideas and somehow certify the good ones as such.

Part of Shiller's bottom line is:

The financial crisis delivered a fatal blow to that overconfidence in scientific economics. It is not just that the profession didn't forecast the crisis. Its models, taken literally, sometimes suggested that a crisis of this magnitude couldn't happen.

This is nonsense, and it is vague. (i) The inability to predict everything need not mean we should throw out current scientific methods, or that the science is bad. (ii) Which models is he talking about? There are plenty of excellent economists, working with off-the-shelf economic theory and empirical methods, who are making plenty of sense out of what we have seen in the last few years. Who is Shiller talking to? What conferences is he going to? Actually, Shiller does not even have to leave town to learn something. He could talk to his colleague Gary Gorton, who knows a lot about derivatives, securitization, and shadow banking, among other things.

The rest of the piece is an appeal to the "human element," "personal judgement," intuition, morality, looking the general public in the eye, etc. How unhelpful. I think I'll stick to science.

What is your general feeling towards Behavioral Economics, professor? I've read a few prominent people who dismiss it as a fad, and others who think it's the future. I'm pretty sure Shiller and Akerlof are trying to set up a research project at the Boston Fed for Behavioral Finance/Macro. Do you know what the feeling is at the Fed towards Behavioral stuff?

Thanks.

Also, what would you say to Jack Nicholson as Prescott and Ed Harris as Kydland?

Economics is a social science and not a natural science. We can't run controlled experiments and our theories don’t deliver predictions that are accurate to the n’th decimal point. Economics, therefore, will never have its Einstein. A nobody will never be able to advance to the top of economics by presenting a new theory of how the economy works, as he/she would never be able to deliver 100% conclusive evidence in support of his/her new theory.

In economics everything is endogenous and thousands of variables move simultaneously. Numerous theories therefore appear to explain the same economic outcome: The recession was caused by an increase in tax rates; no, it was caused by drop in government spending; no, it was caused by a drop in money supply; etc. We don’t have enough time series data to identify good theory, but perhaps with 200-300 years of additional quarterly data and four to six further great recessions we will be able to get somewhat closer to an approximation of the ultimate theory.

Economics as a science is very susceptible to the Max Planck dictum: "A new scientific truth does not triumph by convincing opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it." Or, more dramatically, "Science progresses funeral by funeral." Making matters even more difficult in economics is the fact that theories often include implicit political ideologies.

Keeping an open mind about new theories, hence, seems to be exceptionally important in economics, and I found Shiller’s contribution well worth reading and very interesting.

On behavioral economics: Some of this seems like a good idea. How could you argue that it is bad to bring ideas from another field (psychology) into economics? On the other hand, I have seen plenty of bad behavioral economics. Shiller, for one, is fond of rushing to irrationality as an "explanation" for everything. What he is calling irrationality is his own failing - it's what he can't explain.

KP,

1. "nobody will never be able to advance to the top of economics by presenting a new theory of how the economy works"

Look at the Nobel prize winners. Arrow, Nash, Hurwicz, among others, got the prize for theory. Prescott and Lucas, for example, got it for presenting new theories of how the economy works.

2. New ideas are a necessary condition for scientific advancement. There are good ideas and bad ideas. Bad ideas will not advance science, so why should I be "open" to bad ideas? In any case, I don't actually see any serious ideas in what Shiller wrote down. It's so vague that you can't do anything with it.

Actually, I saw a piece of "Terms of Endearment" the other night. The thing is pure schmaltz, but Nicholson is quite funny. Daniels in the film does indeed look like yours truly at the same age. I don't know about now. Has the guy lost his hair?

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